In theory, it was all so simple. Since inflation could not happen if the money supply was held stable, all you had to do was control the money supply and – no more inflation! The productive economy would rapidly adjust to the new monetarist discipline and would benefit – along with everyone else – from low inflation.

True, early attempts to define the money supply ran into trouble, when money turned out to be a surprisingly slippery concept. The attempt to measure the money supply was therefore abandoned, and reliance was placed on the crude instrument of controlling money’s price. The simple task of raising or lowering interest rates as appropriate was handed over to bankers who could be relied upon not to be swayed by the inflationary pressures to which elected politicians were subject.

Raising interest rates, though, turned out to be far from painless and had a real and debilitating effect on many parts of the economy, not least on the wealth-creators as opposed to the wealth-owners. It was also, as a counter-inflation instrument, slow-acting and poorly focussed. But, despite these obvious downsides, it did seem to work, even if it took a long time and did a lot of damage in the process.

That is, until now. Alan Bollard has been raising interest rates for a couple of years now, but the housing market remains stubbornly buoyant, bank lending is correspondingly rising, domestic consumption refuses to die back, imports continue to surge, our current account is in record deficit. No one can be confident that these inflationary pressures will abate. So, where to from here?

Current orthodoxy allows the Reserve Bank few options. The Governor is now caught in a trap of his own making. If he raises interest rates yet further, this will in turn lift the exchange rate, sending our current account deeper into the red. The productive economy, on which our prosperity depends, will suffer further damage.

Most worryingly, if recent experience is anything to go by, inflation will go on unchecked, whatever damage is done to the real economy. If interest rates cause the dollar to rise, consumption will be stimulated. People will go out and spend on cheap imports for as long as every dollar will buy up to 20% more than it should. And they will stick with investing in houses rather productive industry for as long as monetarist orthodoxy and an overvalued dollar depress profits and growth in those industries and while high interest rates offer a better short-term return.

In vain will the Governor lecture New Zealanders on their failure to save and their predilection for investing in houses rather than in productive capacity. He has no one to blame but himself. Economics is a behavioural science. People do not respond to lectures, but to economic realities.

And the longer he persists, the worse his predicament becomes. The weaker our productive economy and the bigger our current account deficit, the more we need high interest rates to attract overseas “hot” money to finance it. And since even that inflow will not fill the gap, we have to sell off yet more assets to foreign owners, making our current account worse with the double whammy of increasingly high interest payments and larger volumes of profits repatriated overseas.

All of this might just about be tolerable if the medicine was working – but it isn’t. Interest rates are no longer effective as a counter-inflation instrument. Indeed, they might even be adding to inflationary pressures.

The initial impact of higher interest rates is of course to raise prices, not reduce them. The counter-inflationary effect is expected to come from restraining bank lending – by far the most potent inflationary factor in our economy – by making it more expensive. But what if borrowers simply absorb the increased cost and carry on regardless?

That is indeed what seems to be happening. This is partly because of the high proportion of New Zealand borrowers who have fixed rate mortgages, so that they are insulated for a time against rate increases, and partly because the continued strength of the housing market has taught home-owners that increased mortgage payments are only a minor offset compared to the constant capital appreciation against which they can borrow at the bank.

Higher interest rates simply become another cost increase which is painlessly absorbed into the cost and price structure of the housing market – and the overvalued dollar also chips in by raising the price of New Zealand assets against assets held overseas.

If the only monetarist means of slowing the housing market is to use an interest rate sledgehammer that kills everything, the time has surely come to look at other options, even if they may all have their downsides. Fiscal measures, particularly within the regime established by the Fiscal Responsibility Act, would certainly be more effective and better directed than interest rate rises. They could include investment incentives designed to promote productive investment. Restraints on certain kinds of bank lending could be put in place.

Monetarists take a surprisingly static view of how the economy works. Their insistence on using high interest rates to drive down prices has run us into a blind alley. Getting off the interest rate and exchange rate roller coaster, and giving priority to the real rather than the financial economy, might actually encourage some sustainable productive growth which would be the best counter-inflation strategy of all.

New Zealand led the way – misguidedly – into the more extreme versions of the monetarist revolution. We now have the chance to make amends by being the first advanced country to recognise the need to change course. The Governor himself has acknowledged the limitations of the current orthodoxy. Let the debate begin!